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Aren’t hedge funds supposed to
hedge? In 2011, as managers swerved in sync with the stock
market’s wild swings, one might have wondered if
hedging is a lost art. Maybe it is, as managers in many
strategies — from equities and market neutral to
event-driven and multistrategy — grappled with the
thorny issue in a year of heightened volatility.

The performance of hedge funds since 2008 illustrates the
problem: They failed to capture much of the upside in 2009 and
then did worse than the markets on the downside last year.

That’s not the way it’s supposed
to work. It’s okay for hedge funds to gain less
than the market when it’s rising — after
all, they are hedging — but when the market goes down,
they should lose less. Theoretically, the alpha masters should
be able to prosper during times of wildly fluctuating
markets.

If these were the hedge fund rules, they have been broken
now. While the S&P 500 was flat for the year, the median AR
Composite Index fell 0.47 percent. Last year, when managers
tried to hedge, it was often too little, too late: They reduced
exposure, then the markets reversed and they missed the run-up,
creating what’s been dubbed the whipsaw effect. In
2009, in contrast, the S&P 500 gained 23.5 percent, and the
median gain for the AR Composite was 14.83 percent.

Even star managers have acknowledged the difficulty of
hedging these days. At his annual investor meeting in late 2010
and in Las Vegas last spring, John Paulson warned that he would
not be using certain hedging techniques because they had become
too expensive. Paulson increased his hedges later in the year,
but it was too late: Paulson’s Advantage fund was
down 36 percent in 2011, while his Advantage Plus sank 51
percent.

Paulson’s losses were among the heftiest, but
other event-driven managers were also hit hard. Typically long,
some resort to shorting indexes to hedge even though they
don’t have overall market risk. But event-driven
managers tend to invest in riskier names, and these fall the
most when the market goes through one of its gut-wrenching
nosedives. That might be one reason the AR Event-Driven Index
was down more than 5 percent for the year — the worst
performance of any AR index by some 100 basis points.

Some managers short indexes instead of individual stock
names because of the unlimited downside potential of short
positions. Shorting individual stocks has also gotten more
costly, in part because prime brokers are having trouble
locating the stocks to borrow. It seems that since the fracas
following the Lehman Brothers bankruptcy, pension funds and
insurance companies have become wary of lending their
securities.

Options, whose prices are a function of time, interest rates
and market volatility, are another way to hedge individual
names; their cost is limited to the premium. But despite low
interest rates last year, puts were extraordinarily expensive
because of market volatility.

Those who have figured out how to short individual names
prospered in 2011. One such manager is Mason Capital
Management, which gained about 5 percent, in part by shorting
credit spreads, property developers and solar energy companies,
according to investors.

Elliott Management was another savvy hedger last year,
netting 4.2 percent in its onshore fund, much of it due to
gains on hedging. Through the third quarter, Elliott reported
that its portfolio volatility protection earned the fund 3.9
percent gross of fees and expenses. Some of the hedges employed
were sovereign credit protection strategies, single-name
high-yield shorts, gold call options and some rates trades.

A subset of event driven, risk arbitrage was also tough to
hedge last year, and the much-anticipated flurry of deals just
didn’t happen. When News Corp.’s bid
for BSkyB fell through last summer in the wake of the
investigation into the Murdochian method of news gathering
— illegal phone hacking — the arbitrageurs
who bet on it lost a bundle. Among them were Perry Capital and
Taconic Capital Advisors. Perry’s offshore fund
fell 7.57 percent for the year, while Taconic’s
offshore event-driven fund ended down 2.7 percent.

Perhaps just as important, funds like Taconic also paid up
for expensive tail hedges, designed to kick in if the market
falls substantially in any single day. In a year when
Armageddon seemed right around the corner, given the shaky
status of the euro, the downgrade of U.S. debt, the Arab Spring
and the Occupy movement, these hedges gained currency
— and became quite pricey. Employing them inside a
regular hedge fund ate into returns last year.

It’s a little bit of the damned if you do,
damned if you don’t. But hedge funds will have to
do better this year to keep their reputations, if not their
assets, intact. AR

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